On Returning Inflation to Target

To gauge the breadth of current inflation and prospects for inflation returning to target, we consider disaggregated measures of CPI infl ation to evaluate trends and then consider diff erent scenarios for the realisation for wages and prices.

Forum ties leading to domestic cost-push pressures above and beyond external sources.
Will the underpinnings to the global dynamics and their domestic equivalents moderate, with infl ation easing? Or will the dynamics of 2021 repeat in 2022 to keep infl ation strong for longer? To gauge the breadth of current infl ation and prospects for infl ation returning to target, we consider disaggregated measures of CPI infl ation to evaluate trends and then consider diff erent scenarios for the realisation for wages and prices.
With regard to the fi rst consideration, while it may have been true initially that infl ation was mostly a phenomenon of external shocks generating price increases in a few volatile components of the CPI, going into 2022 this story no longer holds up. With regard to the second consideration, if expectations are realised, wage and price dynamics may become embedded into contracts beyond 2022, making for a self-reinforcing infl ation path. It matters for forward-looking monetary policy whether underlying infl ation is broad or narrow and whether fi rms and workers expect to recoup the costs incurred in 2021 in their wage and price contracts of 2022 and beyond.

Measuring underlying infl ation
The Bank of England's Monetary Policy Committee, and most other major central banks, sets its policy in order to achieve price stability which is defi ned in terms of a certain aggregate price index, which in the Bank's case is the Consumer Price Index. Naturally, a variety of shocks will disturb the trajectory of this index at any point in time, which blurs the signal from any one data point. The Bank's remit (HM Treasury, 2021) recognises that optimal monetary policy may look through some disturbances which knock the infl ation rate off target in the short term, so long as in the longer-term trend, price growth is anchored at 2%. Responding to every up-and-down move in the CPI would whip-saw monetary policy, potentially causing instability in fi nancial markets and introducing unnecessary variation in the broader macroeconomy. However, this raises the question of how to estimate trend growth or socalled underlying infl ation.
Attempts to measure underlying infl ation can be broadly split into two categories: exclusion-based indices, which refl ect infl ation only in some parts of the overall basket; and estimation-based measures, which use some type of statistical model to extract the underlying signal from the In the latter half of 2021, infl ation in the United Kingdom as measured in the Consumer Price Index (CPI) surged, more than doubling from 2% in July to 5.5%, for the 12 months to January 2022. Survey data on price and wage developments tell the micro story. The most recent summary of business conditions by the Bank of England's agents reported that pay awards in 2021 were 2.5%-3.5%, with some awards of 5%-7% (Bank of England, 2022a). Firms in the latest Decision Maker Panel (DMP) survey reported price increases of 5.4% on average for the three months to February (Bank of England, 2022b). This momentum from prices and wages is pushing up expectations for 2022, with agents reporting expected pay settlement of 4.8% 1 and fi rms expecting price increases of some 4.5% for 2022. If realised, headline infl ation could stay strong for longer, well into 2023, particularly if exacerbated by the geopolitical events of early 2022.
Before assessing the prospects for returning infl ation to the 2% target, and the role for monetary policy, it is important to review the sectoral sources of the 2021 infl ation surge. First, going into the pandemic, the UK's CPI price level was roughly trending along its 2% infl ation path, unlike in the US or the euro area, where infl ation had been persistently below target. Second, global demand recovery and supply limitations, as well as geographical shipping mismatches in 2021 yielded robust infl ation momentum, particularly for energy and core goods -all of which are mostly external to the UK economy. However, a domestic supply-demand imbalance has also been apparent in the UK with production constraints, shortages of lorry drivers, and other widespread recruiting diffi cul-

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The theme common to these measures is to remove the especially volatile component of infl ation which is driven by perhaps large but in the end transitory shocks. The resulting series may then plausibly be considered a measure of underlying or trend infl ation. The next section off ers another attempt at stripping out the most volatile component by classifying components directly by their historical realised volatility.

A volatility-based measure of infl ation
For the simplest example (displayed in Figure 1), we compute and then aggregate into volatility buckets realised volatility of the 85 items in the Offi ce of National Statistics' CPI basket over the period starting with the Bank's independence in 1997 and ending before the onset of the COVID-19 pandemic. We do not average across the pandemic period since the price-setting behaviour in a time of lockdowns and supply bottlenecks may be fundamentally diff erent to what came before. However, we do fi nd that the properties of the CPI and its components were largely consistent with the behaviour before the coronavirus pandemic -conditional on a deep recession and the subsequent recovery. Only from the second half of 2021 onwards do we see a marked diff erence in the aggregate behaviour of CPI infl ation.
Alternatively, one might compute volatility separately for certain subsamples or on rolling windows. We fi nd, how-noisy headline series. Examples of the former are various commonly watched "core" infl ation rates, which typically strip out those components that are a priori considered too volatile to carry much of the long-term signal, such as the prices for energy and food. Examples of the latter range from simple pointwise means and medians of the monthly distribution of infl ation rates -sometimes "trimmed" to exclude outliers within the month -to more complex statistical estimates extracted, for instance, using principal component analysis and dynamic factor models. 2 While exclusion and inclusion of certain components is usually determined by convention or common knowledge, attempts have been made to inform the choice by statistical methods. For example, the ECB's "Supercore" series (O'Brien, 2018) isolates those components of the infl ation basket that are estimated to be sensitive to economic slack. These components ought to be those most infl uenced by monetary policy based on a Phillips curve framework. On the other hand, the Atlanta Fed's "Sticky Price" index (Bryan & Meyer, 2010) attempts to single out components that change prices only very infrequently, i.e. those that are less sensitive to overall economic conditions. 3 Forum soon? Or are cost-price dynamics that push the volatile components being embedded throughout. If robust infl ation can be found in more than just isolated pockets, how will it get back to target? Surely, macroeconomic conditions exist that are consistent with achieving the infl ation target while infl ation in the low-volatility components is north of 3%. But that implies that there needs to be a drag, i.e. infl ation below 2%, from other components.

Strong for longer
Looking into and beyond 2022, there is a key role for expectations, which if realised could mean that infl ation stays strong for longer. For fi rms, 2021 exposed them to signifi cant cost-push factors including increasing costs of shipping and raw materials, export-related costs, rising wholesale energy prices and increasing wage pressures (arising from both staff shortages and underlying wage pressures such as minimum wage increases). In the Bank's DMP, some fi rms also mentioned higher costs associated with insurance, debt repayments, CO 2 emission reductions and coronavirus safety measures (Bank of England, 2022d). Will fi rms be able to pass these costs into their prices in 2022?
The DMP shows an asymmetry in the relationship between prices and sales. Firms that experienced faster sales increases due to COVID-19 also hiked their prices at much steeper rates than fi rms reduced their prices as their sales fell. 4 This convex price profi le using fi rm-level data is mimicked in research using macro data that fi nds a convex Phillips curve relating infl ation to slack in the economy (Collins et al., 2021).
The MPC's November 2021 Monetary Policy Report (Bank of England, 2021) recognised that downward price rigidity is an upside risk to the infl ation outlook as the near-term eff ects of COVID-19 pandemic fall away. Firms' pricing expectations from the DMP survey solidify this upside risk for 2022. Similarly for wages, Bank research shows wage demand and infl ation expectations are correlated, and that items that consumers buy frequently, such as energy, food and clothing have particular salience for their short-term perceptions of infl ation (Bonciani et al., 2022). Given the rapid increase in prices for some of these salient items, it is not surprising that consumer expectations for infl ation in the short term have jumped, too. Wage compression has been a feature of the period after the global fi nancial crisis, but the environment of higher price infl ation and tighter labour markets may herald a regime change for wage outturns. ever, that the relative ranking of components by volatility does not materially change in that case. The relative sensitivity of CPI components to diff erent shocks, as measured by their higher moments, appears to be relatively stable even if their fi rst moments can swing quite signifi cantly.
As is well known, headline infl ation has now surpassed its previous post-independence peaks, reaching 5.5% in January 2022. A large part of this increase is being driven by high and rising energy prices but even when adjusting for their direct impact, infl ation rates are still well above the Monetary Policy Committee's (MPC) target. Figure 1 plots these series (headline and core CPI infl ation) alongside two volatility-based measures of infl ation.
The fi rst series, which is the weighted average infl ation excluding the most volatile fi fth of components measures, as expected, is something close to core infl ation. What is more surprising -and perhaps more worrying -is the behaviour of the lowest-volatility fi fth of components. By defi nition, these components tend to adjust relatively little over time. Some examples are pharmaceutical products and hairdressing, but also housing rents, and restaurants and canteens. These latter two each account for over 8% in the CPI basket and are therefore important for the behaviour of the aggregate.
Note that the low volatility components do not anchor infl ation to the target -indeed they run above the target for the whole period since 1997. But, infl ation within this bucket has been confi ned to rather narrow and stationary bands around some mean for most of the last 25 years, with the mean apparently having shifted down by about one percentage point in the post-2011 period (see dotted line in Figure 1). More research is necessary to assess the cause of this step-down and is beyond the scope of this article. However, since infl ation was -on average -at target both before and after 2011, the step-down in the lowest-volatility bucket must not have decisively driven aggregate infl ation. It is tautological but the mixture of shocks and policy hitting both high-and low-volatility components was consistent with achieving the 2% infl ation target in both regimes.
Starting in the second half of 2021, however, rates in the lowest-volatility bucket have left their range of the last decade and now look more in line with the period of 2011 and before. High infl ation clearly is no longer limited to components that are typically quite volatile, but now has seeped into those that typically are rather stable. This raises a number of diffi cult questions for a monetary policymaker at the current juncture: Are these components just experiencing a pandemic-related jump to settle down Forum three very simple assumptions: One scenario holds wages fi xed until they reach their pre-pandemic trend. A second continues the historical trend from the latest data point. A third scenario shows what would happen to wages if there was another strong settlement season in 2022. According to the Bank's agents, some further upward pressure on wages is to be expected in the coming months as fi rms and workers adjust to the higher costs of doing business and costs of living (Bank of England, 2022a). To stand in for such a scenario, we let average weekly pay rise by 3% over the second quarter, then return to its pre-COVID-19 trend growth. From the perspective of wage infl ation, wage settlements even only as strong as last year would keep wage infl ation strong for longer.
Ultimately, however, it is fi rms' pricing decisions that generate infl ation. The next set of charts explores what would happen if the goods price increases of 2021 were repeated in 2022, as surveys suggest fi rms will attempt to do. Over the course of last year, core goods prices had already risen markedly and now stand about 4% above their trend level (Figure 3, left-hand panel). They have come off the top a little bit in January but are obviously still well above trend. If in fact this decrease in goods prices continues, so much the better for infl ation rates and household purchasing power in the near term. After all, any decrease in goods prices is directly defl ationary. For now though, similar to the wages example above, we show three scenarios for goods prices where levels at least are sustained. The only diff erence to wages is that,

Scenarios for infl ation based on alternative historical outturns and expectations
The earlier section showed that the behaviour of infl ation within diff erent buckets of the volatility distribution could be revealing a fundamentally changed macroeconomic environment. The surveys implied that current price and wage momentum is being refl ected in 2022 wage and price expectations, which suggests an embedded dynamic. Naturally, this is speculative and we will continue to learn more from macro data and micro surveys as we go along. However, even assuming that we are not on the cusp of a regime change and that the mixture of shocks in the economy will return to what it was before the COV-ID-19 pandemic, we are still faced with the possibility of staying in uncomfortable territory with infl ation above target for longer than initially thought.
This section shows some simple arithmetic exercises about how wages and goods prices might evolve going forward if some of the 2021 wage and price increases are repeated in 2022, as has been suggested by the Bank of England's surveys and agents' intelligence.
Consider wages fi rst. As Figure 2 shows, wages have rebounded from their 2020 trough, leading to high year-onyear outturns in 2021. As of January, average wages were slightly elevated compared to their pre-coronavirus trend but showed little sign of spiralling. For the arithmetic exercise, to project forward from the current data, we make Forum about competitors' pricing can aff ect the optimal pricing behaviour of the fi rm, and thereby aff ect aggregate outcomes. A loosening of supply constraints, perhaps paradoxically, could also support faster price growth in the short run as loosening supply is met with even stronger demand. 5 Global trade issues seem more set to push up prices. Although shipping rates look like they may have peaked, they are still very high compared to their history, raising the cost of trade around the world. UK Purchasing Managers' Indices refl ect this ongoing disruption. While variation in delivery times generally has small eff ects on aggregate prices, the especially severe disruptions in 2021, which are likely to persist, will likely show up in prices into 2022.
Further, the UK's evolving trading situation post-Brexit may exacerbate any infl ationary impulse from global goods and commodity markets by adding another wedge of administrative costs as well as changing the competitive landscape and perhaps altering the variety of products available. Bank research estimates a widening Brexit wedge on the supply side of the economy of some 2% by the end of 2024 from the pre-pandemic trend. Already, 5 See for example Cesa-Bianchi and Ferrero (2021) who, in US data, fi nd evidence for complementarities at the product level through which sectoral shocks can cause aggregate fl uctuations.
in the upside scenario, we assume a 4% rise in prices over the whole of 2022, consistent with the outturn for 2021.
From the right hand panel it is immediately apparent that all of these pricing scenarios imply robust goods price infl ation rates by year-on-year metrics. If we take the current level of prices as given, most infl ation in the near term is already baked in. Even if prices stopped rising right now, goods infl ation would arithmetically increase to over 6% in February. Peak goods infl ation does not diff er much between scenarios, either: It is going to be between 6% and 8%, and sometime in the fi rst half of this year. What does diff er signifi cantly is the length of time for the price shock to work through and return infl ation to trend.
In the two more benign scenarios -where goods prices are unchanged or only grow at their historical annual average of 1.2% -core goods infl ation reaches its pre-COV-ID-19 average by the end of the year. But in the scenario where fi rms are able to push through another 4% price increase, infl ation remains elevated through all of 2023. From a mechanical perspective, any shocks to the price level only wash out after one full year has passed. This exercise assumes that the jump in prices is not repeated in 2023 or beyond -i.e. that cost infl ation does not get embedded in pricing behaviour.
There are a variety of underlying factors which might push up prices in 2022. Uncertainty is one of them: Chan (2021) fi nds that, in a model with incomplete information, beliefs Forum both UK export and import volumes have been tracking well below their G7 peers.
Finally, not discussed here, but extremely important for the near-term dynamics of infl ation is the impact of energy prices and the revision of the Ofgem price cap. The Russian invasion of Ukraine has already caused another shock to energy prices and -given the lagged calculation of the cap -will likely have sizeable eff ects on consumer prices beyond the current year. 6

Implications for monetary policy
Waves of surging infl ation -from the reopening from COV-ID-19 and associated energy and goods-price infl ation, from the Russian invasion of Ukraine and further leg-up in energy prices, and likely from the most recent coronavirus lockdowns of production facilities in China -have pushed core and headline infl ation in many advanced economies to highs not seen for many decades. What was transitory at fi rst has spread to more product categories and into labour markets, raising even the least volatile components of the UK CPI, perhaps heralding a regime change to where prices in these categories once again trend above the infl ation target.
Current price and wage expectations coming from the DMP survey are inconsistent with the Bank of England's 2% target and, if they are realised in 2022, are likely to keep infl ation strong for longer, which could embed a reinforcing cost-price dynamic. The longer wages and prices stay above target, the more persistent the headline infl ation. A fi rst defence against persistence is to lean against expectations. However, expectations are not the only factor relevant for monetary policy. The price increases already in train and those embedded via the Ofgem price cap will hit household income, and likely will constrain purchasing power and therefore pricing power over non-energy goods and services. In considering the appropriate policy path to achieve the infl ation target in the medium term, it is necessary to evaluate the tenacity of wage and price expecttions against expected aggregate demand outcomes.